Cryptocurrencies, stablecoins, digital currencies: how do they work?

Cryptocurrencies, which first emerged in the wake of the global financial crisis, offered a vision of money free from central bank control. Since their creation, they have boomed into a highly volatile and divisive asset class.

Bitcoin, the most traded cryptocurrency by volume, has a market value of around $700bn alone, according to CoinMarketCap, but can suffer huge losses from a single tweet.

Policymakers have grown increasingly concerned about potential fallout from cryptocurrency markets, launching crackdowns and regulatory consultations. Proponents argue cryptocurrencies offer an alternative to centralised financial systems, a way to wrest control from central banks and stimulate innovation; but the market has also been exploited by fraudsters, while their creation has raised environmental concerns and the spectre of wider financial implications.

Here is a guide to the key concepts:

What is a cryptocurrency?

Cryptocurrencies are pieces of digital code that are traded as an asset. These digital coins are built on blockchain, a decentralised ledger technology that offers a permanent, immutable record of transactions divided among different nodes. Proponents claim that this offers greater autonomy and privacy. New units are created by computers solving complex equations, a process known as mining.

The oldest and best known cryptocurrency is bitcoin, which launched in 2009. Today there are thousands of digital coins available to buy and sell, but only a handful — such as bitcoin and ethereum — are traded on key exchanges.

Cryptocurrencies have steadily crept into the mainstream over the past year as bitcoin gained popularity, and its price has soared, despite its high volatility. In the first few months of 2021, bitcoin rose 116 per cent to a high of over $60,000 per coin, before crashing over 40 per cent since mid April. Crypto exchange Coinbase became the first main company in the space to go public, listing on the Nasdaq stock exchange in March.

There are also growing concerns about the environmental impact of cryptocurrencies as the process of “mining” some popular coins is highly energy intensive. This process not only creates new coins, but also is crucial to the functioning of the overall network because this is how transactions are logged and verified.

Fears about possible market manipulation, scams and the use of digital assets to finance nefarious activities, such as ransom payments demanded by the hackers who shut down the Colonial fuel pipeline in the US this month, have also caught the attention of global regulators, including the US, China and South Korea.

What is the difference between bitcoin and alt-coins?

In the broadest sense, cryptocurrencies can be divided into two camps: bitcoin and the thousands of “alt-coins” created after it. While Bitcoin remains the top cryptocurrency by market cap, several other coins have gained traction among investors.

Ethereum, the second largest cryptocurrency by market cap, has emerged as a contender for bitcoin’s crown owing to its use in the rapidly growing world of decentralised finance, or “DeFi”. Aimed at eliminating intermediaries, DeFi uses computer codes known as smart contracts to conduct and settle transactions in real time.

While many alt-coins are designed for serious use cases, there is a large class that are designed as jokes, and some have also been involved in “pump and dump” schemes that have caused investors to endure losses.

Among the alt-coin universe, dogecoin has achieved huge popularity in recent months. Launched as a joke in 2013 and named after a popular meme of a Shiba Inu dog, Tesla chief executive Elon Musk has plugged the coin, causing its value to rise nearly 7,000 per cent since the start of the year despite suffering losses during a cryptocurrency rout last week.

What is a stablecoin?

Unlike most cryptocurrencies, stablecoins claim to be pegged to other assets, including traditional “fiat” currencies such as the US dollar or other digital assets. They promise lower volatility, which makes them useful for converting between fiat and other cryptocurrencies.

Stable coins have seen a huge surge in popularity mainly because they are used in DeFi transactions. Central banks are also exploring them as part of projects around digital currencies.

However, many stablecoins lack consumer protections and provide patchy, frequently unaudited accounts of the reserves meant to back their coins. Tether, the $60bn stablecoin, was fined $18.5m by the New York attorney-general over allegations it lied about its reserves. It did not admit or deny wrongdoing in the matter.

What is a central bank digital currency?

Central bank digital currencies are official efforts to create a digital version of money using distributed ledger technology. CBDCs are central banks’ attempts to keep control of the monetary and payments system. They would be reserve-backed currencies and could use some of the blockchain technology originally proposed as a way to decentralise markets.

These efforts have accelerated as policymakers have grown concerned that private initiatives such as Facebook’s proposed cryptocurrency could have effects on cross-border money transfers and the effectiveness of monetary policy.

In most countries, CBDC plans are at an early stage. Officials are considering key questions such as whether the digital coins would be usable for international transactions or just domestically, as well as assessing the impact of these decisions on the broader financial system.

The most advanced projects are in China, Sweden and the Bahamas. However, a survey from the Bank for International Settlements showed that central banks representing a fifth of the world’s population have said they would likely issue a digital representation of their domestic currencies. Emerging markets showed interest in these projects, but in recent months discussions have picked up in the US, Europe and the UK.